Get to Know These Downside Catalysts

I guess if your kid wakes up in the middle of the night after a nightmare, it’s helpful to be able to console him or her by saying, “What you can’t see can’t hurt you.”

Otherwise, it’s obviously a dumb thing to say. Of course things you can’t see — or don’t know about — can hurt you. In fact, it’s usually the stuff we don’t see coming that gets us. Cause if we saw it, we’d (hopefully) do something to protect ourselves.

I’ve discussed the current bull market threat that we can see a lot lately. That’s the one where slowing Chinese economic growth is dragging commodity prices and emerging market prices lower. This was the theme of the 12% stock market sell-off we saw in August.

China’s slowdown is likely to continue to weigh on stock prices for two reasons: One, slowing growth in China and emerging markets will mean less consumption. Demand for oil, for instance, is down slightly in China. And rumors have been swirling that iPhone sales in China are weak.

One look at the Brazilian economy will tell you all you need to know about how China is affecting emerging economies.

The other reason China’s growth will weigh on stock prices concerns the U.S. dollar. The only economy in the world that’s able to show consistent (albeit weak) growth is the U.S. And when there is concern about global growth, investment money will seek out the safe haven of the U.S. dollar.

A stronger dollar always takes a bite of multinational corporate profits.

What We Don’t Know is Scary

Investors have known about the slowing Chinese economy for at least a year now. Chinese leaders have openly acknowledged that Chinese growth will suffer as the country starts to transition to a more consumption-based economy.

But still, you’ll recall that back in August, investors wondered what was behind the stock market sell-off. Was it just China? Or were higher interest rates in play, too? Was the U.S. economy coming unhinged? 

When you have a +1000-point down day like we did on August 24, it’s a pretty clear sign that investors aren’t exactly sure what’s going on. They are selling first and asking questions later.

Now, we can say that at least some of the Chinese economic slowdown is priced into U.S. stocks. That’s what happens when investors get a clear look at a catalyst — they factor it into asset prices.

Of course, that’s not to say China’s economy won’t perform worse than expected, in which case stocks would head lower. And it’s also not to say that China won’t be better than expected. The point is simply that the market is good at quickly pricing in the things it sees.

That, in turn, is why investors must try to anticipate the things the market does not yet see. I know that might sound silly. How do you see what you can’t see?

Well, the simple answer is that you can’t. But if you keep looking, you’ll find things the average investor is missing. 

Debt and Earnings

As it happens, the next “unknown” downside catalyst is also one that I’ve discussed before here at Wealth Daily. We could call it the “share buyback bubble.”

Low interest rates, record-high profitability, and weak U.S. growth have encouraged companies to use their cash to buy back their own stock — over $1 trillion a year for the last few years. As I wrote back in April:

When a company buys back shares, it is lowering the number of shares outstanding. That, in turn, makes earnings per share (EPS) rise because you’re dividing the total earnings by a smaller number.

The problem right now is that earnings per share (EPS) are showing small improvement. Something like 70% of companies are beating first quarter earnings expectations. But revenue isn’t rising. 50% of the S&P 500 is missing revenue expectations.

In other words, much of the earnings growth we are seeing isn’t due to an improved economy — it’s simply the result of companies having fewer shares outstanding.

But here’s the thing: Companies haven’t really used their extra cash to buy back stock. Instead, low interest rates have made it seem more attractive to borrow the money used for buying back shares. 

Right now, U.S. corporations owe more in interest payments than they ever have. JP Morgan says that interest payments for “high-grade” companies rose $119 billion in just the last year. Again, that’s higher than it’s ever been before.

The problem, as I suggested before, is that real earnings are falling at the same time that dividends and share buybacks are at historic highs.

Wall Street uses the term “interest coverage.” Interest coverage measures how many times a company can pay off its interest expenses out of earnings. Coverage has fallen from 16.7 times to 13.8 times in just the last year. That’s because debt is rising at the same time earnings are falling.

Back in 2006, when stocks and the economy were deemed healthy, 38% of U.S. companies had coverage ratios between zero and 10. Today, nearly half of all U.S. companies have coverage ratios between zero and 10. 

Problem? What Problem?

Just like the parable of the ant and the grasshopper, any business needs to spend some portion of an economic boom preparing for the economic bust.

Companies today are not doing that. Instead of improving their balance sheets, companies have actually put themselves in worse financial shape. 

This isn’t an issue right now. But it will become a big problem when companies stop buying back their own stock. My best guess is that happens when (if?) the Fed hikes interest rates.

Be on the lookout: At some point, we will see a very large change in earnings forecasts that takes investors by surprise.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

The Wealth Advisory on Youtube

The Wealth Advisory on Facebook

A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.